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Post ch 7 income tax questions? We filed ch 7 in 2011 and now have some serious questions about the rental property.

Charlotte, NC |

case - filed ch 7 in 2011 , discharged in May 11 , case closed in Jan 12' . Filing included cc debts , first mortgage and mortgage on rental property . Properties were all under water . Now we're doing our 2012 return , my CPA says that I have to reduce the cost basis on the rental by the amount discharged . IF I were to sell that house any $ from that is considered a GAIN and I have to pay taxes on it . What ? I know I am personally cleared of all debts II . The bank has a lien on the house and any sale of that that the bank would get the proceeds to cover the loan balance . Why would my CPA suggest that I get the sale proceeds and must PAY taxes on the sale ( gain ) ? I can understand if it sold for more than the loan balance and that amount i pay taxes . It doesn't make sense . HELP !

Attorney Answers 3

Posted

Unfortunately, your accountant is correct; however, since you had debt discharged in bankruptcy, the amount by which the basis of your property must be reduced will depend on how much debt you still have after the bankruptcy discharge and the total bases of all property you still have, plus any cash on hand.

In your case, because the rental property is still subject to the mortgage debt, that debt should be included in determining whether the aggregate bases of your property exceeds your total remaining debt. Unfortunately, however, it's impossible to give you a quantitative answer without knowing all of the facts and circumstances of your case. You should speak in more detail with your accountant and make sure you understand exactly how much he thinks the basis must be reduced, and why.

www.nytaxcounsel.com

My answer does not constitute legal advice and may not be relied upon by anyone for any purpose and does not constitute an attorney/client relationship or an offer to form such a relationship. This disclaimer is intended to be fully compliant with the requirements of Treasury Department Circular 230 and the terms thereof are fully incorporated by reference. If you wish to consult with me please contact me at dana@nytaxcounsel or visit my website at www.nytaxcounsel.com

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Asker

Posted

Thank you for your response Mr. Atchley. I purchased the rental at 150k, put 15k down and mortgaged 135k. Current balance at time of ch filing was 128k. I have been claiming depreciation every year. Per ch 7 I am free from all liability, the bank has a lien on house and would received any proceeds to recapture their loan amount. 100% of the mortgage was included in bankruptcy. If I reduce my cost basis by that amount than I have zero cost basis. Lets say I sell it for 128k (mortgage balance - bank gets all of that) then why would I have to take the tax burden and pay capital gains on it, since I did not get any of it? If I sell for above that than I can understand... as the bank can ONLY keep what is owed them.. the 128k.

Dana Whitney Atchley

Dana Whitney Atchley

Posted

A lot will depend on how much depreciation you've already claimed and the current fair market value of the property. However, although your personal liability for the mortgage debt was extinguished (technically speaking, the liability is still there, the bank is just permanently forbidden from trying to collect it from you personally), the debt still encumbers the property because the lender can always foreclose on the property to satisfy its debt. As such, the mortgage debt that still encumbers the property should still count as one of your liabilities for the purpose of determining how much to reduce the basis of your assets. To take your stated facts as a simple example: assume that you have no other debts other than this mortgage debt; further, assume that you have no NOLs, tax credits, or capital loss carryovers, that you have no cash on hand, and that your only asset is this one property which you've rented out for the past 10 years and which you've never made any capital improvements to since you bought it. Also assume that the purchase price is allocated 20% to the cost of the land and 80% to the cost of the house. Under those assumptions, the aggregate basis of all your property is $150k, the amount you originally paid, less depreciation of about $44k (I'm trying to keep the numbers simple), or $106k. Also, the total sum of your liabilities is currently $128k. Under that scenario, your aggregate basis of $106k does not exceed your total liabilities of $128k, and so there would be no reduction in the basis of your property. If you then sold the property for $128k, you would recognize ordinary income of ($128k, minus $106k) = $22k. Conversely, if you had never taken any depreciation on the house (because, for example, it was held for investment rather than for rent), then your basis of $150k would exceed your debts of $128k, and your basis would therefore be reduced by the lesser of (a) the total amount of discharged debt excluded from income, or (b) $22k. Effectively, in the first scenario, where you had $22k of gain upon sale of the house, the rules are making you recapture tax benefits you already received from deducting the depreciation against the rental income you earned, so those tax benefits represent real cash - the taxes you didn't have to pay on the rent income - that you've already had the benefit of. That may seem harsh given your situation, but at least it's not as bad as having the entire basis reduced to $0, which would cause you to realize income of $128k if you sold the house.

Asker

Posted

Wow.. Awesome explanation sir. You're explanation makes a lot of sense. The way my accountant explained it I thought I had to pay taxes on the full proceeds I we were to sell the rental, as I assumed zero basis. We purchased the rental in 08' for 150k and have claimed the depreciation from inception. Haven't done any major renovations or improvements to it. We tried to sell to my wife's brother and his wife through conventional means however the house only appraised at 105k.. and the deal fell through. I can't do a short sale since since it's family.. (arms length transaction). My last hope is to be able to ask my bank to allow an assumption. Else we may just walk away from the rental.

Bruce Givner

Bruce Givner

Posted

Dana is always correct.

Posted

In most circumstances, forgiveness of any portion (or all) of a loan is considered taxable. It seems that your CPA gave good advice.

The above is not intended to be legal advice, but may be used for general information. Please contact an attorney for specific help tailored to your needs. www.figgardenlaw.com

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Bruce Givner

Bruce Givner

Posted

Sean is correct.

Posted

I suspect you might have been depreciating the property over the years which adjusts your basis downward.

If you sell the house for more than the basis (or adjusted basis) that is gain regardless if you actually net any proceeds.

For example, investor buys a property for 200,000, takes out a $175,000 interest only mortgage, and owns it for 7 years. Each year, the investor claims $12,000 in depreciation on his taxes. The investor goes to sell the property (capitulates due to real estate crisis), short sells it, and only gets $150,000. However, the adjusted basis of the property is $104,000 ((12,000 x 8) - 200,000)). So, this investor has a realized, taxable, gain of $46,000 even though the investor is not pocketing any money.

Also, the bankruptcy has nothing to do with this issue. The issue is straightforward capital gains tax. If you have gain, it is taxable; so you must find either an exception or other losses to offset.

The CPA does seem to know what he or she is doing...sorry.

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Posted

Thank you for your response Mr. Berkus. I purchased the rental at 150k, put 15k down and mortgaged 135k. Current balance at time of ch filing was 128k. I have been claiming depreciation every year. Per ch 7 I am free from all liability, the bank has a lien on house and would received any proceeds to recapture their loan amount. 100% of the mortgage was included in bankruptcy. If I reduce my cost basis by that amount than I have zero cost basis. Lets say I sell it for 128k (mortgage balance - bank gets all of that) then why would I have to take the tax burden and pay capital gains on it, since I did not get any of it? If I sell for above that than I can understand... as the bank can ONLY keep what is owed them.. the 128k. Comments?

Matthew Scott Berkus

Matthew Scott Berkus

Posted

I may have misread your question. In any event, see IRS publications 4681 and 523 http://www.irs.gov/pub/irs-pdf/p523.pdf http://www.irs.gov/pub/irs-pdf/p4681.pdf

Bruce Givner

Bruce Givner

Posted

Matthew is correct.

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